7/29/2006 @ 12:35PM

The Philosopher Kings Of Hedging

Steven Drobny’s inside look at hedge funds couldn’t come at a more appropriate time. Everyone should know what makes these private investment partnerships tick, where they are putting their gobs of money and how they see the markets going forward. Hedge funds, after all, are believed to account for up to half of all stock trading and are the controversial focus of a debate and legal fracas over their regulation.

Drobny’s Inside The House of Money ($30, John Wiley & Sons, 2006) sheds more light than ever on the minds behind the largest global macro hedge funds, those giant pools of money that see the whole world as their oyster (unless they’ve gone short on shellfish). They make big bets on crude oil, Eurodollars, gold, Japanese bonds, Brazilian soybeans, sugar, cotton, you name it–investments that most ordinary investors would likely avoid.

Drobny humanizes his hedge fund operators, showing them as global thinkers out to exploit any opportunity in inefficient markets, but not as a force out to destroy the financial system. It is a welcome relief from the harping of a skeptical crowd of onlookers who seem to see the forces of darkness lurking behind every one of these partnerships.

The book reveals the intricacies of thinking like a hedge fund manager. Marko Dimitrijevic of Miami’s Everest Capital liked Argentinean banks, went short with Japanese government bonds when they were yielding only 0.45% (very clever, because interest rates were bound to rise and depress the bonds) and was also playing the markets in Cyprus, Mongolia and Uruguay. He also recommended
YUM Brands
, owner of Kentucky Fried Chicken and Pizza Hut, as the best American stock to play the growth in China.

There’s some brilliant common sense here, valuable to us mere mortals. Dr. John Porter of Barclay’s Capital believes that momentum trading is the flavor of the month and that “people who are indexed are going to get killed.” Porter anticipated the knee-jerk response of the U.S. Federal Reserve to loosen money when tech stocks sold off in 2000. He loaded up on two-year Treasuries at 6.75%, which was a bet that interest rates were headed down and the value of the notes were headed up. It was a highly profitable play when the cost of money dropped to 1%.

Drobny also shows how managers have learned from past hedge fund failures. Peter Thiel of Clarium Capital in San Francisco refuses to become the next Long Term Capital Management. He places stop-loss orders on every trade– a very tough discipline–but one that limits disastrous losses.

One shortcoming of the book is that since hedge fund operators are so nimble, they may well be long out of the positions they revealed to Drobny in 2005. That’s the nature of hedge funds; they don’t have investment committees and can dump a position in five minutes and get back in it the next day. What’s compelling among these money managers is their intensity in educating themselves about nations and bottom-up individual investment opportunities.

Many years ago, Dwight Anderson, then with Tiger Management, now with Ospraie Management in New York, explored palladium mines in Siberia to ascertain the true world shortage of that precious metal. Tiger made a killing when Palladium soared from $120 an ounce to more than $1,000 an ounce.

An underlying theme of the work is that macro traders “thrive on dislocation and economic upsets. Macro traders always do better when the world economy is tanking,” says one of the managers. So, unlike the proverbial market optimists, macro operators like disasters such as currency crises or political upheaval, because they produce the panic selling and market bottoms that provide the biggest upsides.

Running through these interviews is an uneasy sense that we’re on the cusp of dangerous times. Scott Bessent of Bessent Capital says, “At some point we will have had The Big One. It’s out there. I don’t know if it’s a financial asset depression or a real depression.”

Dr. Sushil Wadhwani, of Wadhwani Asset Management in London, says, “What you’ve got now is huge asset-market distortions, and one of these days, the chickens will come home to roost, and when they do, there’ll be huge opportunity.”

So, for the wealthy investors in hedge funds, these are prospective opportunities. For the ordinary investors, these are warning signals to be prudent and protect your assets.